Rakoff and the Roundtable

April 6, 2012

It's been more than 70 years since Woody Guthrie introduced the famous line, "Yes, as through this world I've wandered I've seen lots of funny men; Some will rob you with a six-gun, and some with a fountain pen."

The ethical breaches on Wall Street in the run-up to the 2008 financial crisis may never be fully known. The non-profit newsroom ProPublica, which won a Pulitzer Prize last year for exposing industry practices that contributed to the meltdown, has identified collateralized debt obligations (CDOs) as a core problem.

The crash of CDOs - collections of mortgage bonds - produced nearly $500 billion in losses that were ultimately absorbed by taxpayers and investors around the world, according to ProPublica. Analysts say there were bigger causes of the crisis, but the creation and handling of the CDOs made it more severe.

The extent to which laws were violated - if at all - is unresolved.

Last fall, Judge Jed Rakoff, a U.S. District judge in New York, rejected a proposed fraud settlement brought by the Securities and Exchange Commission against one of the firms involved in marketing CDOs - Citigroup Inc. The judge said, in effect, that he'd had enough of diluted justice. Rakoff's ruling, now under appeal, has made him a hero in some circles, and a heel in others.

Citigroup is accused of selling $1 billion of risky mortgage securities in early 2007 without telling investors it was simultaneously betting against that debt. A short time later, the housing bubble burst.

According to the SEC's complaint, by unloading dubious assets on unwitting investors, Citigroup realized net profits of about $160 million while investors lost more than $700 million.

In reaching a deal, the financial conglomerate agreed to pay a $285 million settlement for "negligence," but admitted no wrongdoing.

"If the allegations of the complaint are true, this is a very good deal for Citigroup," Judge Rakoff observed.

In 2007 alone, ProPublica reports, Citigroup marketed to investors more than $20 billion worth of deals backed by home mortgages, "most of which failed spectacularly." There are allegations that Citigroup sold dozens of CDO packages that were of low quality and meant to fail, but the SEC focused on just one.

Goldman Sachs and JP Morgan Chase have already reached SEC settlements in similar cases, but ProPublica's Jesse Eisinger observes: "Neither the Citigroup settlement nor any of the others come close to matching the profits and bonuses that these banks generated in making these deals."

If you work for a company, you likely believe your employer has little tolerance for fraud - especially fraud on your part. You're probably right, of course.

When it comes to the corporate world, a lighter touch seems in order.

The chief executives of some 200 large U.S. companies took a look at Rakoff's decision and recommended it be tossed out. The group, known as the Business Roundtable, issued a statement describing Rakoff's rejection of the settlement as "novel and potentially dangerous."

Mark Perry, a lawyer for the CEOs, said allowing Rakoff's decision to stand would result in courts "micro-managing" agencies' enforcement decisions, while delaying recoveries for victims.

Rakoff took a different view. He said Citigroup was protecting itself against potential private lawsuits by refusing to admit guilt. Such an approach is common in SEC negotiations, but this time the judge refused to sign off.

Rakoff said the combination of charging Citigroup only with negligence and then allowing it to settle without either admitting or denying guilt was "a double blow" to the defrauded investors. The judge also said he couldn't determine if the settlement was "fair, reasonable, adequate and in the public interest" when he had no clear idea if Citigroup had, in fact, committed fraud.

The 2nd U.S. Circuit Court of Appeals wants to hear more arguments, but has already chastised Rakoff for overstepping his authority. According to a Reuters report, the appeals court found "no reason to doubt" the SEC's determination that its settlement with Citigroup was in the public interest.

A trial scheduled by Rakoff on the charges against Citigroup is on hold. The SEC and Citigroup will likely succeed in getting his decision overturned, the appeals court says.

By all accounts, a trial would be costly, complicated and uncertain. Citigroup wants none of it, and neither does the SEC. If Rakoff's decision stands, future SEC settlements (whether token or excessive) might be difficult or nearly impossible to reach.

So this is how justice is playing out, down the road from the mortgage securities fiasco. A financial manipulation that was vast and brazen - and seemingly fraudulent - reigns too messy to warrant a judge's "novel" prescription for a trial, or at least an admission of guilt.